ttf whitepaper response to global fx code, …...include a misallocation of capital. if the costs of...
TRANSCRIPT
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Village
DefiningWhatTransparencyMeansinthe
WholesaleForeignExchangeMarket
July2017
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Contents:
AbouttheTransparencyTaskForce 3
ExecutiveSummary 4
Rationale 6
MarketStructureRecap 7
HiddenFXCosts 10
ThecaseforPortfolioCompression 17
ElectronicTrading:Anewtimescale18
HowMuchDoFXTransactionsCost?25
RetailFX;thesignificanceforpensionsavers28
Recommendations30
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AbouttheTransparencyTaskForce
The Transparency Task Force (TTF) is a campaigning community, dedicated to driving up
levels of transparency in financial services, right around theworld. It believes that higher
levels of transparency are apre-requisite for fairer, safer andmoreefficientmarkets that
willdeliverbettervalueformoneyandbetteroutcomestotheconsumer.
Furthermore, because of the correlation between transparency, truthfulness and
trustworthiness,theTTFexpectsitsworktoimprovethereputationofthefinancialservices
sector.
TheTTFseekstooperateinacollaborative,collegiateandconsensus-buildingway;focusing
on solutions,notblame. Ithas over160volunteersorganised into9 teams.Each team is
workingonseparatecampaigninitiatives.TheTTF’sForeignExchangeTeamisledbyAndrew
Woolmer,CoFounderandCEOofNewChangeFX.
http://www.transparencytaskforce.org/
LeadAuthor:XavierPorterfieldCFA,HeadofResearchatNewchangeFX
SupportingAuthor:JessicaBilcock,GovernmentRelations,TransferWise
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ExecutiveSummary
Thesecondandfinal instalmentofanewGlobalFXCode,designed“topromotearobust,
fair, liquid,open, andappropriately transparentmarket”hasnowbeenpublished.MiFID2
and PRIIPs come into force in January 2018, requiring fiduciary managers and service
providerstoaddresstheirFXprocesses.
TheGlobalCodeisavoluntary,principlesbasedsetofstandards.Thepurposeofthecodeis
toprovideaharmonised,globalstandardofbestpractice intheglobalFXmarket. Indeed,
thefirstpartofthecode,releasedinMay2016offeredusefulexamplesandcasestudies.
The Global Code came into being as a response to political pressure following various
reviewsandenquiriesintoForeignExchangepractisesinnumerousjurisdictionsaroundthe
world. Due to its size, (over one third of theworld’s global FX volumes are exchanged in
London)theUKgovernment’sFairandEffectiveMarketsReviewplayedakeyroleinframing
thediscussionoftheissuessurroundingthewholesaleFXmarket.
Achievingagreementonaglobalsetofstandardsisalaudableachievement.However,the
releaseoftheglobalcodedoesnotaltertherealitythatOTCmarketsremainfundamentally
opaque. Asetof standardscannotchange that. Theareasof thecodewhichcaused the
most controversy were related to issues related to trading ahead of clients (to source
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liquidityforclients)andthepractiseof“lastlook”.Intheend,nofinalsetofprinciplesthat
governthesepractiseswasagreed.
ToachievetransparencyinForeignExchange,clientsmustbeabletobeabletodefinewho
theyaretradingwith,preciselywhentheyareexposingatradetothemarket,andatwhat
absolutecostthetradehasbeendone.
This paper seeks to explorewhere the FXmarket remainsopaque, andhow transparency
canbeachievedinthesethreecriticalareas.
TheTTFrecommends:
- CustodiansnottransactFXonaprincipalbasis.
- AllFXtransactionsshouldcomewithreliabletimestamps–thisistimeimmediately
priortotheorderarrivingwiththetradingdeskthatexecutestheorder.
- Thearrivalprice formeasuring themarket impactofpoint in timeFIX transactions
should take the market mid-rate available at the moment the fixing order was
transmittedtoanintermediary.
- Transaction costs should be measured against objective, independent data that
reflectsthebestmarketpriceavailableinthemarketwhentheorderwassubmitted
totheirintermediary
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- For retail transactions, these transaction costs should be disclosed in full to the
consumer, including the revenue percentage included in the provider’s reference
rateontheday.
Rationale
The foreign exchange market is a delocalised, global market where foreign exchange
transactionscanoccuraroundtheclock.AclientsittinginCaliforniacantradewithamarket
maker in London for a fundwhich is registered inHongKong. Theperception that theFX
marketisriggedpromptedaco-ordinatedresponsefromregulatorsandmarketparticipants,
cognisantthatunlessactionwastakeninconcert,poorbehaviourwouldsimplymigrateto
jurisdictionsofferinglowerregulatoryconstraints.
Lack of transparency in OTC markets can have a number of undesirable effects. These
includeamisallocationofcapital. IfthecostsofparticipatingintheFXmarketareopaque,
orifthemarketisperceivedasbeingrigged,participationwillbediscouraged.Thiscanlead
to a casino image of the FX market where participation is seen as a form of gambling ,
leavingcurrencyexposuresunderhedged.Thisunderhedgingmeansthatendinvestorsare
exposedtounnecessaryorsub-optimalrisks,allofwhichincreasethecostburdenonsociety
asawhole.
Removingopacitycouldencouragegreatermarketparticipationandincreasetheefficiency
of FX market participation. The global FX code represents a major achievement in
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international co-operation, but unfortunately, a number of the features of the FXmarket
whichcreateopacityhavenotbeendealtwith.Thispaperseekstoremindregulatorsand
stakeholdersthattheworktowardsasuitableleveloftransparencyisnotcomplete.
MarketStructureRecap
TheFXmarket isdecentralised. Liquidity isdisaggregatedovermanydifferent venuesand
counterparties.Moreover, FX is tradedonabilateral rather thananexchangebasis. This
means that every FX price is customised for each client. The ‘going rate’ in the Foreign
Exchangemarketdependsentirelyonwhoisaskingthepriceofwhom.
Historically, the wholesale FX market was two-tiered. An exclusive ‘interdealer’ market
segmentallowedbankstosourceliquidityfromeachotherandadealer-customersegment
allowedcustomerstosourceliquidityfromthemarket-makingbanksinturn.
The interdealer segment has now lost its exclusivity. In 2005 interdealer prices and data
finallybecameavailabletothecustomersegmentforthefirsttime.Coupledtochangesin
thecredit structure through theevolutionofPrimeBrokerage, thisgavenon-bankmarket
participantstheabilitytotradeonthesamepricesasbanksand,moresignificantly,tomake
pricestoo.
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ThemajorityofFXvolumeisnowconductedonmarketvenueswhereliquidityflowsinone
direction only: frommarketmaker to customer. This reflects the legacy of a two-tiered
systeminwhichcustomerscontinueto‘take’pricesandpaymarketmakers,despiteowning
liquidity.
With liquidity disaggregated into numerous pockets or pools,marketmakers provide the
necessaryintermediationtosourceliquidityforclients.Marketmakersdonottypicallyearn
explicit fees, instead, they seek tomake profits by earning a bid-ask spread. This spread
represents a risk transfer fee. The client closes their risk by transferring it to themarket
maker–andpaysafee.
Whenmarketparticipantsfaceeachotherasprincipaltheycompeteoverthetermsofthe
deal. The interests of the principals are diametrically opposed. Market makers seek to
maximisethespreadtheycanearn,whilecustomerstrytominimizethespread.
Inadditiontospread,participantscompeteovertheinformationcontentofthetrade,which
can be much more valuable. FX prices are formed before a transaction occurs, via
expressionsofinterest.Thepriceshownisjustanindication,andthepricecanbewithdrawn
if it becomes unfavourable to themarketmaker showing the price. But in the process of
showingapricetoapotentialbuyer, themarketmakerhasgleanedvaluable information
aboutmarketinterestatthatprice.Marketmakersseektoavoidfallingintothetrapofthe
buyer’scurse,otherwiseknownasadverseselection-owningacurrencythatisworthless
thantheypricetheyjustpaidforit.
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Changes to the regulatory environment, particularly with respect to the capital charge
appliedtoriskweightedassets,havediminishedtheappetiteofmarketmakerstoallocate
capital tomarketmaking.Thishasmeant that traditionalmarketmakers (thebanks)have
been less willing or less able (or both) to warehouse risk. This has led to much shorter
inventoryholdingperiodsandasignificantincreasein‘matchedprinciple’trading.
Matched principle trading entails a market maker effectively white labelling the liquidity
solution of another provider. Typically they will add a mark-up to someone else’s rates,
ratherthanactuallyearningthebidaskspreadbytakingprincipalrisk.
Much ofwhatwe callmarketmaking actuallymore closely resembles exploitation of risk
free arbitrage. Market making institutions seek to preserve their informational edge,
because the source of their profits is not from taking principal risk. Instead, profits come
frombeingbetter informed than their clients– and charging risk transfer fees for riskless
arbitrage.
Thenewrulesonriskweightedassetshaveencouragedthosewantingtotakemarketriskto
investinnon-bankmarketmakinghedgefundsratherthanallocateriskdirectlytoin-house
market making. Unsurprisingly, the new entrants into the market making space are less
constrainedinhowtheyusetheirowncapitalthanthebanks.Thesefirmsarenowstepping
intorolesthatonceweretheuniquepreserveoftheinterdealerbanks.
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Aswediscussedabove,inprincipaltrading,marketparticipantstradeontheirownaccount,
puttingtheirowncapitalatrisk.Principalactorsseektobuyandsellontermsthataremost
favourabletothemselves.Inamatchedprincipletrade,afacilitatorbringstogetherabuyer
andaselleronanagencybasis,withouttakingtheothersideofeitherparty’s trade. The
transaction is completed simultaneously with the facilitator’s remuneration remaining
independentoftherateatwhichthetransactionoccurred.
However, as the recent Fair and EffectiveMarkets review concluded, there are instances
whenthedistinctionbetweenagencyandprincipalareblurred.
HidingFXCosts:
1. AgentstradingasPrincipals
Despite a spate of lawsuits highlighting the problem, a significant number of investment
firmshavenegotiatedarrangementswithcustodians,grantingthecustodianamonopolyon
theFXtransactionsthatoriginatefromthefund.Thisobligestheunderlyingfundinvestors
toacceptthecustodian’sFXratesevenwhentheyarenotcompetitive.
A Russell Research paper “It’s time for more choice in FX” published in 2004 raised
awarenessof theextent towhich FX transactions couldbe costing investors. Theirwork,
basedonthousandsoftrades,showedthatthemajorityofcustodialFXtradeswereheavily
skewedtotheworstratesoftheday.
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The issue came to a head in 2009 when the largest pension fund in the United States,
Calpers, sued their custodian. Theheart of theproblem is that custodiansmay choose to
executeFXtradesonaprincipalbasis,puttingtheirowninterestsindirectcompetitionwith
theinterestsoftheunderlyinginvestorswhoseassetstheyhold.
Investors caneasily be confusedas towho they aredealingwith, andonwhatbasis.Are
their funds traded with someone looking after their interests, under the protection that
agencylawsprovide,oraretheytradingwithsomeoneonacompetitivebasis,asaprincipal,
withouttheprotectionofagency?
The evidence from years of Transaction Cost Analysis suggests fund investors are much
betterservedwhenfiduciariesarenotgiventheopportunitytotradeagainsttheinterestof
thecustomerstheyserve.
TheFairandEffectiveMarketsReview(2015)callsfortheGlobalFXCodeto“setstandards
for the treatment of clients and counterparties. This section of the code should address
issuessuchasthepreventionandmanagementofconflictsofinterest,especiallyconcerning
mixedprincipalandagentroles”
Andyet,custodialFXcontinuestobeofferedto investmentfundclientsonaprincipalrisk
basis,andtheGlobalFXCodedidnotaddressthisissue.
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2.TimeStamps
A study conducted by researchers at Brandeis International Business School andWilliams
College, (Olser, Savaser, Nguyen 2012) found that asset managers may be choosing to
outsourcetheirFXtradinginorderto“shroud”costinformationfromunderlyinginvestors.
Therationaleforthisstrategyisthatunderlyingfundinvestorsmaynotnoticetheefficiency
gains from negotiating currency deals individually. Improved performance might be
accredited to other factors. On the other hand, negotiating deals individually requires a
trader, technology and trade processing staff, all of which are likely to result in higher
running costs that are much easier to identify. Transaction efficiency is hard to isolate.
Costsaremuchmorevisible.
Olser,SavaserandNguyenstudiedthecompletetradingrecordofamid-sizeglobalcustody
bankwhichincluded70,000transactionsin25currencies.Theyfoundthattheaveragecost
of non-negotiated FX trades was 19 basis points, well above the 2-3 basis points clients
mightexpecthadtheyexecutedonanegotiatedbasis.
When FX orders are “shrouded”, prices are set relative to the high and low for the day.
Becauseacustomer’slossisaprincipalcounterparty’sgain,thedistributionofcustomerfills
areheavily skewedto theworstpricesof theday.Asevidencedby research fromRussell,
(2004opcit,revisitedin2010)andRecordCurrencyManagement(2011).
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ThemovementofassetflowsthatnecessitateFXdealsareknownlongbeforetheFXtradeis
done. CustodialFXdealersareabletoacquiretheinventorytheyrequirediscretely,filling
clientordersbeforetheymaketheirclientaprice.Theyarethenwellplacedtoaddamark
uptotheirownacquisitioncosttomakesuretheyalwaysmakemoneyonthetrade.This
effectivelyturnstheFXtradeintoarisklessarbitragewhichdoesnotjustifytheearningofa
risktransferfee.
Theseeffectsareparticularlyamplifiedinrestrictedcurrencies,wherethecustodiancannot
by lawdoanFXdealwithoutanunderlyingassettransaction. Thecustodianwill insiston
theassetdealsettlingbeforetheFXhedgeisdone,whichmeansthatinvestorsoftenwait4
days before their FX is hedged. During this time the custodian can opportunistically pre-
hedgethedeal–andguaranteethemselvesaprofit.
Abuse isdifficult tospot.Custodial tradereportscontainnoreferencetothetimenorthe
relevantmid-market ratewhen the trade took place. Thismakes it extremely difficult for
assetmanagerstoidentifytheirrealisedFXexecutioncosts.
Toencouragetransparency,theFairandEffectiveMarketsreviewcalledformandatorytime
stampingonallFXtrades. Thissimplestephasbeen ignored intheGlobalCode,allowing
custodianstocontinuetheirpractiseofhidingtimestamps.Obligingcustodianstorelease
timestampsofnon-basecurrencyequityandbonddealswouldofcoursebesimpleenough
–andenableFXcostmeasurement.
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EvenwitheffectiveTime-Stamping,automated,non-negotiatedFXdealsremainvulnerable
tootherformsofcostshrouding.
3.The4pmFix
TheWMR Fix is a valuation tool used to value trillions of dollars in common investment
benchmarks.Because theunderlyingequity andbondbenchmarkprovidersuse theWMR
Fixtovaluethebenchmarkportfolio,passivefundmanagershaveanincentivetotrytopeg
their FX transactions to the benchmark rate. This serves to minimize the tracking error
betweenthebenchmarkvaluationrate,andtherealizedexecutionratesoftheirportfolios.
RespondingtoconcernsabouttheintegrityofFXBenchmarks,theFinancialStabilityBoard
taskedaspecialworkinggrouptoreviewFXBenchmarks.TheirworkfocusedontheWMR
4pmfix,andtheECBfixing,thetwomostwidelyusedbenchmarks.
The working group final report (September 2014) concluded, “it is the incentive and
opportunityforimpropertradingbehaviourofmarketparticipantsaroundthefix,morethan
the methodology for computing the fix (although the two interact), which could lead to
potentialadverseoutcomesforclients.”
TheEuropeanCentralBanknowactivelydiscouragestheuseofitsownECBreferencerate
fortransactionpurposes.
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However, the FSB working group did not review the cost to investors of using these
benchmarks.
Independent research conducted by numerous firms and institutions (including but not
limitedtoNewChangeCurrencyConsultants,PragmaSecurities,NewCityInitiative)reveals
thatusingtheWMRFixishighlyinefficient.
As fixing orders must be submitted at least 30 minutes before the fix, market making
institutionscan(andinmanycasesmust)beginpre-hedginglargeorderswellinadvanceof
theFix itself. Speculators canof course see thisactivity,andareable to jumpaheadand
frontrunit,whichcreatesskewinpricing,pushingthepriceagainsttheusersoftheFix.This
meansthatthecosttocustomersisoftenmanytimeshigherthantheFixitselfshows–but
they cannot see this cost because they have achieved the fixing price, and are only ever
shownthecostofexecutionwithin the fixingwindow. The fixingwindowopensafter the
skewhasbeenachieved.
Usersof the4pm fixareparticularly vulnerable to these skewcostsatperiodends,when
largeportfoliorebalancesthatmatchpopularinvestmentbenchmarksoccur.Theamountof
moneytrackingparticularbenchmarksensuresthatthedirectionofthemarketforthefixis
predictable. Thiserror is thencombinedwith thepopularmisconception thatFXmarkets
arehighlyliquid.InfactFXmarketsarehighlyilliquid,withamaximumofUSD14.4million
dollarsasecondbeingtradedinEURUSDgloballyatthebusiesttimeofday.
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In lieu of time stamping trades, custodians and managers often pretend to offer
transparencyfortheirtransactionsbydeclaringthattheywillconvertcurrencyattheWMR
fixprice.
Becausemarket impact canonly be seen in the context of the trading activity immediate
beforeandafterthetrade,marketimpactistoallintentsandpurposescompletelyinvisible
totheunderlyinginvestorsinafund.
The choice to use the 4 PM fix is simply another shrouding method, chosen to hide
transactioncosts.Whatismore,thisparticularshroudingmethodismassivelyexpensive.
NewChangeFXconductedastudycomparingexecutionratesusingatimeweightedaverage
price and the 4 pm fix. Assuming passive investors will normally be positioned in the
directionofthefix,thestudyfoundthatusingtheFixforEURUSDtradesresulted inanet
costtoNAVof3.6%overayearcomparedtotransactingatatimeweightedaverageprice.
Comparing this result to realised trades in EURUSD of UK and US based assetmanagers,
NewchangeFXfoundthat investorswere incurringbetween60%and70%of thesecosts -
that is about $23,000 permillion. These are costs that are unreported, as the timestamp
usedistheopenofthefixingwindow-andwillcontinuetobeunreportedunderMiFID2.
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When a fund had no contractual obligation to use the 4pm Fix for some index tracking
purpose,costshroudingmaybeafactorinthechoicetousetheFix.
TheCaseforPortfolioCompression
Costshroudingisaspecialcaseofopacity,butuseoftheFIXalsopresentsanotherproblem.
Itisnotefficient.ThespecialworkinggroupmandatedbytheFSBtoinvestigatetheuseof
FXbenchmarks“supportsthedevelopmentofindustry-ledinitiativestocreateindependent
nettingandexecutionfacilitiesfortransactingfixorders”(Section7,Point6oftheForeign
ExchangeBenchmarksFinalReport)
Intheirreview,theFSBworkinggroupfoundthatclientswereusingtheFIXtotrade,when
nettingmight be amore cost effective solution. The problem is that appropriate netting
facilitiesdonotexist,orarenotwidelysupported.
Marketmakersliveonflow.Nettingoftradesreducesthevolumeofflowthatisavailableto
marketmakers.A recent studybyNewchangeFXbasedon theFXexposuresof just4UK
pensionfundsfoundthatnettingcouldreducetheircombinedFXcostsby60%.
Byexecutingeach transaction individually, rather thannettingdown toproducea smaller
market exposure, FX volumes are larger than they need to be. Portfolio compression can
offer substantial cost savings. The problem is that market makers have no incentive to
support or create external netting facilities. This would seem to offer an opportunity for
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disruptivenewentrants.ButheretheFXmarketpresentsastructuralobstacle.Becausethe
dominantFXmarketmakersarealsodominant inclearingandsettlement it isdifficult for
moreefficientmethodsofexecutionsuchasexternalnettingfacilitiestoemerge.
Despite the vested interest of incumbents, a number of portfolio compression initiatives
have been launched. For the time being these services are only available to banks, but
LMRKTSaportfoliocompressionserviceprovidefornonCLScurrenciesdoesplantoopenup
to some buyside firms. OTCmarkets remain dependent on credit, which creates a tiered
hierarchyofwhohasaccesstotheseservices.Ineffect,unlessauniversalaccessapproach
can be found, portfolio compression can become another differentiator, re-introducing a
softerformoftwotieredmarketwherethebestnamescanbenefitfromcompression,while
othersmaynot.
ElectronicTrading-Anewtimescale
Electronic trading has become the dominant medium for conducting Foreign Exchange,
accountingforupto65%ofaveragedailyvolumes.Thedevelopmentofelectronictrading
hasintroducedanewdimensiontohowmarketmakerscangainanadvantagesoverprice
takers.Timeismoney!
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Electronictradingandvoicetradingdonotoccurinthesametimescale.Reportedresponse
timesfromanumberofECNplatformsareintheorderof300microseconds.
However,itisextremelyunlikelyacustomerwouldbeabletocompleteatransactionwitha
marketmakerwithin this time frame. The response time from amarketmakermight be
anywherebetween10and1000timesslower.
Price slippage occurs when the actual transaction price differs from the price when the
decision to tradewasmade. Firmpricing inForeignExchange is still rare.Themajorityof
prices are displayed as an indication of interest, which can bewithdrawn at amoment’s
notice. If thepricecanbewithdrawn,customerscanwonderwhetherthepricewasreally
thereatall.Thisgivesrisetoaphenomenonknownasphantomliquidity.
One of the areas that has caused controversy in the FXmarket is how banks have been
applying last look. Last lookensures the client is alwayswrongand that theprice-maker
securesarisk-freeprofit.Itisanembeddedcomponentoftrading,andthankstoveryweak
handling of the issue by the sponsors of the Global Code, it remains so. The issues are
complicated and the Global Code simply ensures that last look can be given more
respectableattirethanusedtobethecase.
Theissuesanddefinitionsareasfollows:
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Latencyslippageiscausedbythetimeittakesforasignaltotraveloveranetwork.
Latencyslippageshouldbesymmetrical.Afterallitissimplytheresultofasignalbeingout
ofdatebythetimetherecipientof thesignal receivesthemessage. Amarketmakerhas
updatedaprice,buttheupdatedpriceisnotvisibletothecustomeryet,whoisattempting
totradeonapricethatisstale.
LastLookslippageoccurswhenamarketmakerhasleftpricesinthemarketthathavebeen
supersededby events. This sounds like latency, but it is not about the time it takes for a
signal topropagate througha system. It is aboutwhether themarkethasmovedand the
marketmakerhasbeenslowtoadjusttheirprices.
Last look addresses a problem where the market maker has been slow to respond to a
changeinmarketconditions,asopposedtoalatencyissuewhichdescribesthetimeittakes
signalstotraveloveranetwork.
The problem arises, and the opportunity for abuse occurs because latency is reported in
differentways.Itmaybeusedtorefertothetimeittakesavenuetoshowapriceupdate
fromliquidityproviders,oritmayrefertothetimeittakesforaclienttotradeonpricethat
hasbeendisplayed.
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LastLook–AdverseSelection
Lastlookwasintroducedbymarketmakersasameanstoprotectthemselvesfromlatency
arbitrage. Prices change in response to new information.Marketmakers will lose if they
make prices to a better informed trader ( a traderwho can respond to new information
quickerthanthemarketmaker),andwinwhentheytradewithcustomerswhoarelesswell
informed.
A price that updates too slowly is vulnerable to being picked off by a trading algorithm
systemthatisabletoreactfaster.Thiscreatesadverseselectionriskforthemarketmaker-
wherethemarketmakermightenduplong(owning)acurrencythathasfalleninvalue.
Last look has created controversy because some market makers have applied last look
asymmetrically,whichistosayunfairly.
Considerthefollowingprocessofhowanorderistransactedonapricestream:
- Clientopensalivestream.ThelivestreamisaseriesofFiXQuoteMessageswhich
arecontinuallycancelledandupdated.
- Clienthits aprice and indoing so instantly sendsanordermessage to themarket
maker.
- Themarketmakeropensaholdwindowfortheclient.
- Attheendoftheholdwindow,themarketmakerrunsatolerancecheck.
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- Ifthedeal iswithinthetolerancecheck,aconfirmation(AC)messageissent, ifnot
thenarejectionmessageissent(NAC).
Thisprocessapplies toall clients. The tolerancecheck iseitherdefined inbasispointsor
USD terms. ByusingUSD terms, the clientwill notbe rejectedon small deals,which can
happen if basis point variances are used. The holdwindow is continually updated as the
machine learns how a client behaves. Both variables are set on a bespoke basis per
client.Thetolerancelevelcanbe'reversed'wherebythebankactuallyacceptsacertainlevel
oflosspertransactionbeforeitisrejected.
Aswenotedearlier,responsetimesarebasedonthetimeittakesasignaltotravelacrossa
system.Thissignalitselfhasvariability-itfollowsasinewave.Itisverydifficulttoachieve
full transparencyonsignal lengthsbecauseof thisvariability,butclearly,movingresponse
timearbitrarily,suchasexplainingtoaclientthereasonforarejectwasbecausethesystem
wasrunningveryslowlytodayareclearlyareasthatarevulnerabletoabuse.
The Request for Quote (RFQ) protocol is typically handled much the same way, but the
openingprocedurestartswiththeclientpullinginaprice,ratherthanreceivingpricesthat
are “pushed” via a stream.Last look canbeemployedonboth streaming and request for
quoteprices.
Whereasapplying last lookonstreamingpricesmightbejustifiedtohandle latency issues,
applyinglastlookonRFQissimplybanksprotectingthemselvesfromthepossibilityofbeing
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pickedoffina‘drivebyshooting’asliquiditygetsconsumedinamarketsweep.Thelastto
price in the sweep is likely to be disadvantaged in much the same way that a game of
musicalchairsalwayshasonechairlessthanthenumberofplayers.
Thenewglobalcodereaffirmsmarketmakers retainsolediscretiononwhethera trade is
accepted or not. This means that the Global Code has retreated from encouraging
symmetriclastlook(rejectingbothfavourableandunfavourabletradesequally).Ifthegoal
oftheGlobalCodeistopromoteappropriatetransparency,failingtoinsistonsymmetriclast
lookcanonlybeafailure.
Symmetric last lookallowsthebanktheopportunitytore-pricetothecustomer,basedon
the information the clienthas transferred to thebank. Itwill always create slippage,but
whereas asymmetric Last Look invariably creates negative slippage, applying last look
symmetrically theoretically creates a situationwhere the clientmight experience positive
slippage.Givenascenariowherethecustomer’sintenthasalreadybeentransferredtothe
marketmaker,inpracticetheopportunityforpositivepriceslippageisslim.
Ontheotherhand,asymmetric last looksimplyprovidesamarketmakerwith theoption,
butnottheobligationtotradewithacustomer,afterthecustomerhasfullydisclosedtheir
tradingintentions.Howisthisfair?
TheGlobalCode’sapproachlegitimisesLastLook,whenamoretransparentsolutionwould
befairer.Justasbilateralmarketsarebasedonmarketmakersbeingabletoquotedifferent
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prices to different people, Last Look is designed so that response times are tailored
individually.Whenthingsaredifferent,itisdifficulttocomparethem.
FirstLook
Electronictradinghasopenedupanewavenueformarketintermediariestogainanunfair
advantage over their clients. By definition, when custodians have a monopoly on the FX
transactionsofafundtheybenefitfrominsideknowledge.
In the last few years there have been at least two instances of financial intermediaries
offeringagency tradingordirectmarketaccess (DMA),whilst simultaneouslyoperatingan
undisclosedprincipalmarketmakingdesk.
Spottingthistypeofabusecanbeverychallenging.InarecentcasetheCFTCwithdrewthe
retail fxbroking licence froma leadingFXplatform, FXCM.The firmdidnotdisclose their
interest in a market making firm that clients were trading with via their platform,
misrepresenting to clients that it’s “no dealing desk” platform did not have a conflict of
interestwith itsclients.Customerscontinuedtobenefit fromverytightspreads,sothat it
mightappearthatclientswerenotdisadvantagedbyFXCM’sbehaviour.
Earningthespreadwasnotthegoalofthehustle. Thevalueoffirst look isthebenefitof
beingabletoselectivelychoosewhichtradestoprice,andwhichto let flowontooutside
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marketmakers.Themarketmakingdesk,byhavingfirstlook,wasabletochoosetradesthat
werefavourabletotheir tradingbook.LastLookcanbeappliedretrospectively, increasing
adverseselection.Firstlookforcesclientsintoadverseselectionprospectively.
Untilseniormanagementspottedthebehaviour,employeesofITG,thebrokerdealer,rana
similarfirstlookoperationintheirUSequitiesbusiness.(SECpressrelease12thAugust2015)
ITGand itsaffiliateAlternetSecuritiesagreed topaya$20.4million fine to settlecharges
thattheyoperatedasecrettradingdeskandmisusedconfidentialtradeinformationofusers
oftheirdarkpool.
Inordertospotfirstlookorlastlookabuses,forensictransactioncostanalysisisrequired,to
quantifyfillratiosandposttradedecaywithindividualcounterparties.
HowmuchdoFXtransactionscost?
The early pioneers of FX Transaction Cost Analysis, firms such as Record Currency
Management or Russell Investments faced particular challenges when they attempted to
uncoverthehiddencoststhatpensionfundswerepayingfortheirFXtransactions.
As noted above, custodians do not typically provide time stamps, nor do they provide a
referencetotheactualmarketmid-rateprevailingatthetimethetransactiontookplace.
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Time stamping is becoming more prevalent and custodians have made improvements to
theiroperations.However, thequestion remains, if everybody receivesa slightlydifferent
price, what should we measure against, to enable comparability across fund managers,
marketmakersandvenues?
Customershavetypicallyaddressedthequestionofslippagebycomparingtheirexecutionto
thepricesthatweremadeavailabletothem.ThismethodseemedtobesupportedbyMiFID
Iwhichproducedarequirementtoputliquidityprovidersintocompetition.
The troublewith this approach is that determining execution costs in thisway is entirely
circular.
For instance, a largeUKassetmanager createdamid-ratedatabase fromBids andOffers
collected from 10 liquidity providers. This ignoredwhether therewas not a better quote
elsewhere,offeredbyacounterpartythattheydidnotdealwith.Choosingtomeasuretheir
costs in this way caused the asset manager to understate their FX transaction costs by
approximately£10millionayear.
Inmethod,thisisonlyalittlebetterthancomparingexecutiontothepricesthatweremade
availabletothefundbythecustodian’sFXdesk,dealingwithamonopolyonthefund’sFX
deals.
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Fromaninvestor’sperspective,weneedtoknowhowatransactionoccurredrelativetothe
bestavailableprice in themarketasawhole.Thiscanonlybedeterminedbyaggregating
bids and offers across a large cross section of venues that is representative of thewider
market.
Because theFXmarket isdisaggregated, theprices fromsingleaggregatedvenuessuchas
EBS or Reuters do not necessarily indicate the best price available in themarket. Using
singlevenuedataintroducessamplingerror.
Cognizant of the increasingly fragmented nature of the market, European regulators
proposed a transparent framework for reporting transaction costs. The Packaged Retail
InvestmentandInsurancebasedProducts(PRIIPS)requiresfirmstocapturethemarketmid-
rateprevailingatthemomenttheorderwascommunicatedtoathirdpartyforexecution.
Moreover, themarketmid-rate(calledthearrivalprice)mustbeaconsolidatedprice,and
notapricefromasinglecounterpartyorplatform.
Applying and recording a consolidatedmid-price (arrival price) is amajor breakthrough in
costtransparency.
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ConflictedData
Asinvestorslearnttotheircostin2013,whenliquidityproviderscandirectlyinfluencethe
price that they are measured against, they will have both opportunity and incentive to
manipulatetherate.
Singlesourcedata thatan investorhas tradedonprovidesacircularmeasurement.When
liquidityisfragmented,measuringexecutionfromasinglesourcemeansmeasuringagainsta
much smaller liquidity pool. For instance, if the average volumeof a trading venue is 10
billionadayacrossall currencies,normalisingvolumes for the tradingpairwill reducethe
volumetoabout2.5billioninEURUSD,which,spreadoutoverthetradingday,mightmean
thattheactualliquidityavailableinallcurrenciesduringasingleminuteperiodmightbeas
littleasUSD4million,orevenless.
Measuringexecutionagainstaratefromthesameplatformmeansthatit isverylikelythe
investor ismeasuring the quality of their trade from their own trade, drinking their own
bathwatersotospeak.
RetailFX;thesignificanceforpensionsavers
Forconsumers,it’sevenhardertounderstandhowmuchtheyarebeingcharged.Asnoted
above,custodiansdonottypicallygiveatimestamp,orreferencetoanactualmidmarket
rate, when conducting transactions on behalf of pension funds - making it difficult to
ascertaintheexactamountpensionfundsarepayingfortheirtransactions.
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Onasmallerscale,thereisasimilarissueataretaillevel.Brokersarenotobligedtoprovide
an independent, non tradeable rate on an ex-ante basis as a reference to the customer
attemptingtotransactinadifferentcurrency.
Right now, banks and bureaux de change are only obliged to provide a ‘’reference rate”
which, under thedefinitionprovided in thePayment ServicesDirective and in the second
Directive, can either be an independent publicly availablemid rate or the provider's rate
offered on the day - which includes their revenue percentage and as such constitutes a
chargetotheconsumer.
Theprovider’srateonthedayisanarbitraryconstruct,setentirelyatthediscretionofthe
PSP, with no regulatory oversight. It is far from an independent yardstick by which a
consumercanunderstandthetotalamountchargedforatransaction- includingtheprofit
percentageimbeddedintherateofferedbytheproviderontheday.
This setup requires an unreasonably high level of financial literacy on the part of the
consumer. Research conducted by YouGov shows that only 10% can understand how to
calculate the charge when presented with a typical banking structure1. On average, high
streetprovidersadd£29.54onatypical£1,000GBP>EURtransaction2inanexchangerate
mark-up inadditiontotransactionfees.Overthecourseof2015,UKconsumersandsmall
1 ResearchconductedbyYouGovsurveyed19,277Europeanadultsbetweenthe8th-22ndFebruary2 Averagerepresentativeofatypical£1,000GBP>EURtransfer,usingtraditionalhighstreetproviders.ResearchconductedbyConsumerIntelligenceinFebruary2017
30
businessespaid£5.6bn in charges imbedded in theexchange rate,despite just20%ofUK
consumersunderstandthattheirproviderimbedsachargeintheexchangerate3.
Recommendations
Thegoaloftransparencyisnottomaketheprovisionofliquidityunprofitable.Rather,itisto
removetheopacitysurrounding liquidityprovisionsothatcustomerscanbesuretheyare
beingtreatedfairly.
As we have seen, the rise of electronic trading provides new ways that information
asymmetries andplainold fashioned cheating canoccur. Thepushof regulation andnew
rulesonthecapitalchargetosupportmarketmakinghasmadeliquidityprovisionlessabout
marketmakers takingprincipal riskandmoreaboutdealersearninga risklessspread. Ina
riskless trade, the economic interest of principles go head to head over information. The
spreadisjustthecherrythatsitsontop.
Identifying and managing conflicts of interest is vital. However, because cost shrouding
strategies are so difficult to spot, and potentially so costly to investors, certain practices
needtobechallenged.
- CustodiansshouldnottransactFXonaprincipalbasis.
3ResearchconductedbyCapitalEconomics,August2016
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- AllFXtransactionsshouldcomewithreliabletimestamps–orthetimestampshould
betakenfromtheassetsaleorpurchaseandnottheFXdeal.
- Thearrivalprice formeasuring themarket impactofpoint in timeFIX transactions
should take the market mid-rate available at the moment the fixing order was
transmittedtoanintermediary.
- Transaction costs should be measured against objective, independent data that
reflectsthebestmarketpriceavailableinthemarketwhentheorderwassubmitted
totheirintermediary.
- For retail transactions, these transaction costs should be disclosed in full to the
consumer, including the revenue percentage included in the provider’s reference
rateontheday.
Theseproposalsmightbeconsideredsomethingofabigbang,butgreatertransparencywill
result in better risk management, encouraging market participants to trade in the best
interestsoftheircustomers.